Opportunities for Action in Financial Services. Trading Places: New Models for Old Exchanges

Transcription

1 Opportunities for Action in Financial Services Trading Places: New Models for Old Exchanges

2 Trading Places: New Models for Old Exchanges Globalization, deregulation, and new technologies are reshaping the landscape of capital markets worldwide, challenging the role not only of traditional stock exchanges but also of every financial institution that issues and distributes securities. As the ground shifts and landmarks tumble, some exchanges will lose their way and forfeit traditional franchises. But those that transform themselves into capital exchanges by offering differentiated products, building world-class infrastructures, and forming alliances or mergers that facilitate the free flow of international capital will find prominent places on the redrawn map. Such transformations require bold strategies to remove inefficiencies, diversify revenue sources, embrace new partners, and become more profit driven. The push for change is coming from all sides. First, issuers and investors, no longer constrained by geography or national borders, are taking a worldwide approach to fulfilling their capital and investment requirements. Second, governments and market overseers are continuing to deregulate exchanges and other sheltered franchises. And last, newcomers as well as established financial institutions are exploiting electronic technologies and connectivity standards to cherry-pick from the traditional exchange model, and they are taking the choicest pieces to create new businesses. The market structure for trading listed securities is therefore in tremendous flux. Investment flows are shifting from domestic national markets to bigger, more liquid international venues. As cross-border investment grows, exchanges are facing stiffer competition from one another as well as from new elec-

3 tronic communications networks (ECNs) and other alternative trading systems. Pressure from customers is forcing exchanges to consolidate in order to provide integrated market access, reduce costs, and improve service. For example, the London Stock Exchange and Frankfurt s Deutsche Börse are crafting a merger, and the New York Stock Exchange is exploring an alliance with Euronext itself an amalgam of the Paris, Amsterdam, and Brussels exchanges. Given the pace of consolidation, it is likely that before long a few securities networks perhaps only two or three will dominate worldwide trading in the stocks of blue-chip companies. These networks will serve as electronic highways for the growing traffic in crossborder capital. To thrive, therefore, it is imperative for traditional markets to become part of these highway systems. Those that fail to do so will find themselves languishing on bleak and lonely back roads. Virtual Global Exchanges The new competitors are providing such services as order routing, matching, and execution, which have long been the exclusive preserve of national stock exchanges. In North America, ECNs, which are essentially electronic order-matching businesses, are rapidly replacing the industry s traditional middlemen specialists and market makers in liquid issues. ECNs offer narrower spreads, lower costs, and faster execution, not to mention trading anonymity. They have not made major inroads into Europe and Asia, where local stock exchanges are highly automated and already operate central limit-order books without market-making intermediaries. But ECNs and other alternative systems are working to extend their geo-

4 graphical reach, stress their cross-border capabilities, and expand their offerings to include fixed-income and other securities. (See Exhibit 1.) Some ECNs, like The Island ECN, which is owned by Datek Online Holdings, have opted to become licensed exchanges in their own right. Others, like Instinet and Bloomberg Tradebook, are spreading their wings even wider, aiming to become virtual exchanges that serve both regional and global markets. Instinet, for example, is a member of 19 exchanges. By securing enough business from the dominant cross-border players, these new market participants can handle both sides of international trades. As they grow, they can execute trades internally with more efficiency than traditional markets. Because technology and electronic communication are critical components of operating marketplaces, software companies have assumed leading roles in organizing and managing exchanges. Working with Exhibit 1. Challenges to Traditional Stock Exchanges Globalization Issuers Investors Intermediaries Technological change Value chain deconstruction 24-hour trading Traditional stock exchanges Concentration Investment capital Price pressure Deregulation Remote access Equal trading access SOURCE: BCG analysis.

5 Nasdaq, Softbank, a Japanese e-commerce company, founded Nasdaq-Japan in June Softbank has also arranged an alliance with the Osaka Securities Exchange. OM Group, an innovative Swedish software maker, merged with the Stockholm Exchange in 1998, and it has developed specialized trading and clearing engines for a wide variety of securities. In addition, OM Group has been the driving force and architect behind NOREX, the Nordic Exchanges Alliance, which is rapidly becoming an important regional trading hub. In today s competitive environment, such international clearinghouses as Clearstream (which was formed by the merger of Cedel International and Deutsche Börse Clearing) and Euroclear are expanding service. In addition to handling fixed-income securities, they also clear and settle domestic stock trades. Because these players can internalize crossborder transactions, they threaten domestic clearing entities and national depositories, just as global ECNs challenge domestic exchanges. Market Strategies If the exchanges are to meet these formidable challenges, they will need to reposition themselves by building on their established strengths. They must ensure that their market structure is transparent and cost-effective. They must protect and expand retail liquidity, while providing ready access to other markets. And they must acquire topnotch processing capabilities in order to retain and increase their pool of issuers and investors. There are several approaches that promise good results. Remove inefficiencies and promote market access. To be more accessible and attractive to domestic and

6 foreign issuers and investors, exchanges first should broaden their offerings all along the investment value chain from securities trading through transaction settlement. Second, the exchanges should install electronic solutions that enhance efficient processing and cut transaction costs. Third, they should deploy openmarket architectures that provide ready access to cross-border players. Fourth, they should move to hybrid price-discovery and trading models that combine central limit-order books (for more liquid issues) with periodic electronic-auction trading (for less liquid securities). And finally, the exchanges should broaden distribution, providing for remote memberships, working with financial institutions around the world, and extending trading hours. Some players are already taking the lead in this race. The Deutsche Börse electronic-trading platform, Xetra, has raised its parent s profile, efficiency, and negotiating power. SGX, Singapore s integrated stockand-derivatives exchange, was Asia s first electronic exchange. The Paris Bourse and the Stockholm market are essentially technology powerhouses that operate exchanges. And Eurex, the European derivatives exchange formed by the merger of the German and Swiss derivatives exchanges, gained competitive advantage with its electronic-trading platform. Eurex has rapidly built its remote membership, eclipsing its domestic membership and becoming the world s biggest derivatives exchange. Diversify products and revenues. Stock markets should view themselves as capital (not stock) market infrastructures. Because securities trading is becoming a commodity business, a wider range of products and services is critical for survival. Accordingly, some exchanges are integrating the trading of equities, fixed-income instruments, and derivatives. And they are seeking leadership and ownership roles in clear-

7 ing and custody services as well as other processing operations. This diversification strategy gives exchanges a broader stream of revenue and makes them more appealing to potential customers. OM Group, Paris Bourse, Deutsche Börse, and SGX exemplify this diversification trend. (See Exhibit 2.) Merge with other markets and exchanges. Through mergers, exchanges can realize economies of scale, improve efficiency, diversify sources of revenue, secure cross-border distribution, and acquire new product capabilities and technologies. A merger can position an exchange as the leader of an emerging regional or global network. For example, SOFFEX and DTB, the Swiss and German derivatives exchanges, merged to share technology and create Eurex. They have now forged a technology-sharing alliance with the Chicago Board of Trade. Euronext (Paris, Amsterdam, and Brussels) and ix-international exchanges (London and Frankfurt) are combining their IT infrastructures. Exhibit 2. Strategic Responses: A Superior Capital-Market Infrastructure Alliances, partnerships, and mergers Robust capital-market infrastructure Strategic responses Liquidity management Risk management Low transaction costs Technology-based competition Ownership structure SOURCE: BCG analysis.

8 Form strategic alliances. Alliances are essential for promoting efficient cross-border access, and they allow an exchange to assume a leading role in one of the rapidly evolving global networks. By definition, alliances are less integrated and more tenuous than mergers. Still, many players, including the New York Stock Exchange, prefer this route because it offers flexibility and is easy to implement. Exchanges seeking partners should look beyond other exchanges and consider software companies as well as ECNs. Archipelago, a Chicago-based ECN, recently formed an alliance to operate as an electronic adjunct of the Pacific Exchange. Alliances with such new competitors can improve liquidity, develop regional and global networks, foster technology sharing, and offer investors and issuers broader distribution. GLOBEX Alliance, for example, a partnership formed by the Chicago Mercantile Exchange, Paris Bourse, and SGX, is providing a technology-sharing platform as well as cross-border trading and distribution through time zones. Demutualize the exchange. This action aligns owner interests with exchange objectives, ends member trading privileges, and opens access to all financial institutions that meet the exchange s trading criteria. There are other benefits to ending cooperative, or mutual, ownership by broker dealers. By focusing attention on returns and efficiency, demutualization improves the use of financial resources. It offers clear incentives to create a high-performance, customer-driven culture that innovates. And because demutualization generates equity capital an important currency for creating strategic alliances and cross-shareholdings it helps finance the improvements needed to compete with the new market entrants. While many stock exchanges are pursuing the demutualization path, OM Group and ASX, the Australian Stock Exchange,

9 have gone a step further: they are now listed companies in their own right. * * * Competitors are racing to provide efficient marketplaces for trading financial instruments of every type, and the pace is accelerating. Exchanges need to implement several initiatives in parallel in order to transform themselves into more competitive, integrated capital markets. An exchange s ability to meet the needs of its most important issuers, investors, and intermediaries will be reflected in its liquidity the key measure of overall success as a capital market. Only the largest and most liquid markets will become members of the emerging trading and clearing networks, both regional and global. Stock exchanges need to transform themselves into attractive capital markets. The day of the protected, dominant national exchanges has passed. Alexander Leeb Antonio Riera Svilen Ivanov Philippe Morel Alexander Leeb is a senior vice president in the Singapore office of The Boston Consulting Group. Antonio Riera is a vice president in the firm s Boston office. Svilen Ivanov is a vice president in BCG s New York office. Philippe Morel is a vice president in the firm s Brussels office. You may contact the authors by at: leeb.alexander@bcg.com riera.antonio@bcg.com ivanov.svilen@bcg.com morel.philippe@bcg.com The Boston Consulting Group, Inc BCG

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